Speech Payments System Reforms: Innovation and Competition

It is a pleasure for me to be able to address the 14th Annual Cards and Payments
Australasia conference this morning.

The subtitle of this conference is ‘Payment Innovation for Banks, Retailers
and Government’. In my remarks this morning, I would like to focus on
the first two words in this subtitle – that is ‘payment innovation’,
as well as the closely related concept of ‘competition’. This focus
reflects the fact over the longer run it is innovation and competition that
are two of the key drivers for a more efficient payments system. Indeed, much
of the work of the Payments System Board over recent years has been focused
on creating an environment in which competitive forces are able to work for
the long-term benefits of consumers, and on addressing some of the roadblocks
to innovation in Australia's payments system.

There are three specific areas that I would like to talk about this morning –
firstly, the recent reforms of the ATM system; secondly, the conclusions of
last year's review of the reforms to the card payment systems; and thirdly,
the architecture and governance of Australia's bilateral systems.

ATM Reforms

As you are no doubt aware, these reforms finally came into effect earlier this month
after a very long and complicated gestation. At their heart, the reforms are
about: improving competition in the provision of ATMs in Australia; increasing
transparency to consumers; and ensuring that there are incentives that encourage
innovation and the widespread availability of ATMs.

As has been widely recognised, the previous arrangements had at least three significant
weaknesses.

The first was that an owner of ATMs – unlike almost every other business in
the country – was unable to determine the price it charged its customers
for using its services. Instead, if a cardholder used an ATM that was not owned
by its bank, the owner of the machine would receive a so-called ‘interchange
fee’ of around $1 from the bank where the cardholder's account
was held. This fee had been fixed for many years, and it was all but impossible
for the owner of an ATM to negotiate a higher fee.

While this arrangement had served us reasonably well in the past, it had come under
considerable strain. As the cost of providing ATM withdrawals had risen over
time, there was a growing risk that non-bank owners of ATMs would find it unprofitable
to deploy machines in many locations. Given that almost one in two ATMs in
Australia is owned by companies that are not financial institutions, the end
result would have been a reduction in the number of ATMs in Australia, ultimately
reducing choice and convenience for consumers.

The second weakness of the previous arrangements was a general lack of transparency.
While ATM owners did not charge cardholders who used their machines, most cardholders
were charged a fee by their own bank – these fees were commonly known
as ‘foreign fees’ or ‘disloyalty fees’. Many banks
also charged their customers a foreign fee when they simply checked the balance
of their account before withdrawing funds. These foreign fees were not displayed
at the time of withdrawal, with financial institutions arguing that the messaging
systems underpinning the ATM system, and the way that transaction accounts
were structured, did not allow this. Instead, the fees were disclosed in banks'
general terms and conditions and debited to the cardholder's account
at the end of the month.

Many people said that they found these arrangements confusing and that they were
not always aware of the cost of using another institution's ATMs. Over
recent times, there was also increased questioning of why many banks charged
a foreign fee of $2 for withdrawals, when the interchange fee they paid to
the owner of the ATM was only around $1. Similarly, there was also questioning
of why balance enquiries often attracted a foreign fee of around $2, when the
interchange fee on these enquiries was, on average, only around 75 cents.

The third weakness related to access. Over several years, the Reserve Bank had received
numerous complaints about the difficulties that new entrants faced when entering
the ATM market. Many of these difficulties stemmed from the bilateral arrangements
underpinning the ATM system. Under these arrangements, new entrants need to
knock on the door of each of the existing players and establish a relationship
with them, rather than being able to enter the system through a single point
of access. Not surprisingly, the existing players have not always rushed to
welcome new participants in the system, which they often see as competitors.

The recent reforms have addressed each of these weaknesses.

They allow the owners of ATMs to determine their own prices, with these prices set
in a much more competitive environment than was previously the case. This is
a much better situation than ATM owners having their revenue controlled by
the banks. The reforms have also greatly increased transparency to consumers,
with this transparency an important part of strengthening the competitive forces
within the system. And the reforms have also led to simplified access arrangements
although, as I will discuss in a moment, more needs to be done here.

While it is still early days, the competitive forces are playing out broadly as expected.
Initially, two of the four large banks announced that they would retain a foreign
fee, albeit a lower one than previously. This meant that their customers would
have been charged twice if they used another institution's ATM –
once by the owner of the ATM, and once by their own bank. In our view this
was against the spirit of the reforms. Not surprisingly, there was a swift
reaction by these banks' customers and, as a result, they have now abolished
their foreign fees. This is a welcome development and is a good example of
the competitive process at work and the power of consumer reaction.

The Reserve Bank has made its views on this issue very clear on a number of occasions.
While we recognise that the setting of foreign fees is ultimately a matter
for each bank, our view is that the system will work better without these fees,
and that the case for them is weak. This is particularly so, given that most
banks charge cardholders a fixed monthly fee for operating a transaction account,
and now that interchange fees have been abolished, the cost to a bank of its
customers using someone else's ATM is very low, almost certainly less
than 10 cents a transaction.

Under the new arrangements, most ATM owners are charging a $2 withdrawal fee, although
one large bank is charging $1.50, and some owners are charging as low as $1.
For balance enquiries there appears to be more variation in fees across institutions,
with some charging the same fee as for cash withdrawals, while others are charging
less than $1, and there are some examples of ATM owners charging nothing. Where
fees are imposed, they are always disclosed before the cardholder withdraws
the cash, or makes a balance enquiry, and they do not apply if the transaction
is cancelled.

Importantly, under these reforms, most cardholders are able to continue to use ATMs
owned by their own institution without charge. The new arrangements also provide
considerable flexibility for small institutions in how they join the ATM system
and how they, and their customers, pay for access to large networks. Some smaller
institutions have established agreements with large networks to provide fee-free
withdrawals to their customers, while others have joined with other small institutions
to form a fee-free sub-network. In a few cases, they have decided to re-adjust
their product offerings so that their customers now pay for withdrawals from
some machines when previously they did not. Overall, however, across the entire
system most cardholders are paying no more for ATM transactions than they were
previously, and may have the opportunity to pay less.

One concern that arose prior to the implementation of the reforms was the possibility
that some ATM owners would impose exorbitant fees in locations where there
was limited competition. To date, these fears have not been borne out, with
the major networks having a single price that applies across the network, or
a cap on the price that can be charged by members of the network.

Over the months ahead, the Reserve Bank will continue to monitor developments closely.
We have asked ATM owners to provide us with details of their direct charges
on a regular basis, including whether charges vary across locations. We will
also continue to monitor foreign fees and transaction volumes and to report
publicly on developments. Interestingly, our liaison so far suggests that the
increased transparency of the fees is already having an effect. In particular,
some ATM owners have reported that the number of withdrawals from their machines
has declined, with some customers deciding not to proceed with a withdrawal
once they are reminded of the cost. We will get a better picture of how extensive
this change has been in a few weeks time, when banks and others report their
ATM statistics to the Reserve Bank for the month of March.

In summary then, we are confident that the reforms will deliver benefits for consumers.
They have strengthened the competitive forces in the ATM system and made the
fees much more transparent to consumers. Equally importantly, the industry
is on a much sounder foot than it was previously. Now that ATM owners can determine
their own prices within the context of a competitive marketplace, they have
an increased incentive to innovate and to grow their networks. Over time, this
will deliver both more choice and more convenience to consumers.

The Conclusions of the 2007/08 Review

The second issue that I would like to talk about is the conclusions of the payments
system review undertaken by the Payments System Board last year.

The review had two central sets of conclusions.

The first was that the reforms had:

improved the competitive pressures in the payments system;

increased transparency;

delivered better access arrangements; and

improved the price signals in the system for consumers

Given this conclusion, the Board saw no case for allowing the schemes to once again
be able to impose no-surcharge rules on merchants, or to require merchants
to accept a scheme's debit cards as a condition of accepting its credit
cards.

The second conclusion was that the improvements in the competitive environment had
made it possible for the Board to now consider stepping back from one specific
aspect of the regulations – namely the regulation of interchange fees.
However, as the Board made clear, it is only prepared to move in this direction
if the industry steps forward to address its ongoing concerns about the competitive
forces on these fees. While these forces have undoubtedly been strengthened
by the various reforms, there remains a significant risk that the unusual nature
of the competitive dynamics in the system could see these fees move higher
if the current interchange regulations were removed and no other changes to
the current arrangements were made. The Board has made it clear that it sees
such an outcome as undesirable, and it does not accept the idea that higher
interchange fees in the credit card system would improve the efficiency of
the overall payments system.

The Board has laid out two possible paths by which industry could address its concerns
in this area. One is for the industry to take further steps to strengthen competition.
These steps could include:

changes to the governance of the EFTPOS system to improve its ability to compete
with the international card schemes;

further modifications to the honour-all-cards rule to allow merchants to accept some
cards, and reject others, based on the costs and benefits of accepting the
various cards;

the development of alternative payment methods to provide consumers with greater
choice when making online payments; and

greater transparency of scheme fees.

While the Board sees changes in these various areas as desirable, it has not been
prescriptive about the precise details of any changes, including the use of
particular technologies or payment products. Instead it has focused on the
general principle of improving competition.

A second possible path is for the international card schemes to commit to limiting
the weighted-average credit card interchange fee to the current level of 0.5
per cent. Such a commitment would obviously address the Board's concerns
that credit card interchange fees could rise if the current regulations were
removed. Also, the Board flagged the possibility that if the schemes were prepared
to make voluntary changes to their scheme rules, other aspects of the current
regulations might also be able to be lifted. This is consistent with the Board's
view that regulation should only be used if industry-based solutions cannot
be found.

When announcing its conclusions, the Board indicated that it would assess industry
progress in August this year. If at that time, its concerns have been adequately
addressed, the regulation of interchange fees could be lifted, probably in
November. Otherwise, regulation will continue, with interchange fees being
reduced further. As the Board made clear at the time, its preferred approach
is to lift the current regulation of interchange fees, but it is not prepared
to do so unconditionally.

So what progress has been made since the conclusions of the review were released?

Here, I think it is fair to say that some progress has been made on both possible
paths, but there is still a considerable way to go before we can see the finish
line.

In terms of the first path – that is, a further strengthening of the competitive
forces – the main positive development is the work that APCA and its
members have done on the development of improved governance arrangements for
the EFTPOS system, including the establishment of a formal scheme to oversee
the system. Invitations have recently been issued to join the scheme and it
is anticipated that it will be up and running later this year.

These draft arrangements look to be a significant improvement on those currently
in place. They envisage a board overseeing the EFTPOS system, with the board
having a number of independent directors. If adopted, the scheme could help
promote co-operation within the system and provide a mechanism for decisions
to be made in the best interests of the system, rather than the best interests
of individual members within the system. Whether this is indeed the case will
depend upon the details, but at least there has been progress in the right
direction.

On a somewhat less positive note, there appears to have been less progress on the
development of alternative online payment methods. Over the past couple of
years, industry participants had been working, through BPAY, on the development
of a new payment method for online payments. Recently, however, despite considerable
work having being completed, it was decided to postpone the project until at
least the middle of this year. Our liaison suggests that while some industry
participants were keen for the project to proceed, others were not. Without
wanting to offer a comment on the merits of the particular proposal, this experience
is another example of how difficult it can be to make progress when all the
main stakeholders need to be on board at the same time. It might also provide
some useful insights into the appropriate governance model for other payment
systems, including the EFTPOS system.

The Bank's recent focus on online payments reflects a couple of considerations.
One is that in many situations, consumers wishing to buy goods online have
few payment choices other than to use a card issued by the international schemes.
This lack of choice weakens competition, and is likely to become a bigger issue
as online commerce continues to grow.

Another consideration is that fraud rates on online transactions appear to be steadily
increasing. Almost half the fraud on credit cards occurs in situations where
the merchant does not physically see the card, with the fraud rate increasing
by around 50 per cent over the past year. If this trend were to continue,
it could undermine consumer confidence in transacting online which would have
obvious costs.

While the international card schemes have made considerable efforts to address this
rise in fraud, more needs to be done to offer consumers highly secure payment
options. One possibility that has been raised by the Reserve Bank before –
and that has been implemented in other countries – is to be able to make
payments to an online merchant from a deposit account using the customer's
internet banking facilities. Such an option, however, is not yet currently
widely available in Australia.

The general point here is that further progress is required in the area of online
payments, both to improve competition in the payments system and to ensure
that online payments can be made safely and securely.

As I mentioned a moment ago, another way in which the competitive environment could
be improved is to change the honour-all-cards rule to give merchants greater
freedom than they currently have to accept and reject cards. We have discussed
this idea with the international card schemes on a number of occasions, and
it is fair to say that they have little appetite for it. However, if sufficient
progress has been made by industry participants in other areas to allow the
Bank to step back from interchange regulation it would consider the case for
using regulation to require the schemes to further modify their honour-all-cards
rules as part of an overall package.

In terms of the second path – that is a voluntary commitment from the schemes
to keep interchange fees to no more than current levels – the Bank has
had several discussions with schemes over recent months. While these discussions
are ongoing, the schemes have not ruled out this possibility, with the discussions
focusing on the practicalities of any commitment, including the need to ensure
that any arrangements are competitively neutral across the schemes. We hope
that further progress can be made here.

We are also discussing various possibilities with the schemes for improving the transparency
of scheme fees. One possibility is for them to disclose the average scheme
fee paid by acquirers for some standard types of transactions. A second is
for the schemes to disclose their ‘rack rates’ for the specific
fees that are most relevant for Australian transactions. And a third is for
the schemes to permit acquirers to disclose to merchants what they are paying
in scheme fees, and provide the Bank with information on the average scheme
fee to allow this to be monitored over time. We have not yet settled on the
appropriate model, but are hopeful that an outcome can be found that promotes
transparency while at the same time respects commercial confidentiality.

The final point I would like to make here is that the Bank remains keen to continue
to explore both of these paths. Time is marching on however, and further progress
is needed. Many in the industry have argued for the interchange fee regulations
to be lifted, and given the changes that have occurred in the payment landscape
since these regulations were introduced, the Bank is prepared to consider doing
so. It will only move in this direction though if industry itself is able to
take steps to address the various concerns about the competitive forces in
the system.

Architecture and Governance

The third issue I would like to address relates to the general architecture and governance
of Australia's payment systems. Over recent years, the Bank has increasingly
focused on this issue. This reflects our concerns that the existing arrangements
are not particularly conducive to certain types of innovation, and that if
changes are not made, there is a significant risk that Australia will end up
with a payments system that is unacceptably behind best practice.

Our main focus has been on the so-called ‘bilateral systems’ –
namely the ATM and EFTPOS systems, as well as the direct entry system that
is used for the payment of such things as salaries and dividends. The term
‘bilateral’ is used here as each of the main participants in these
systems has bilateral business and technical links with each of the other participants.
This is in contrast to almost all overseas payment systems, and the BPAY and
credit card systems in Australia, where institutions join a ‘scheme’
and thus do not need to establish direct bilateral relationships with each
member in the system.

These bilateral arrangements have generally served us well over many years, and were
useful in the original development of the systems. They are, however, not particularly
friendly to new entrants. As I said earlier, the access arrangements that have
been put in place for the ATM system represent an improvement over previous
arrangements, but more needs to be done. In particular, there is a strong case
for access to be further streamlined so that a new entrant to the ATM system
does not need to go and talk to all the existing players to enter the system.
The same is true for the other bilateral systems.

Perhaps even more importantly, these bilateral systems are characterised by co-ordination
problems which can slow the pace of innovation. None of these systems has an
‘owner’ or a ‘manager’. And none of them are overseen
by a board and management whose job it is to promote and develop the system.
Not surprisingly then, none of them has a particularly good record of innovation.
Over the years, various proposals have been floated for change, but progress
has been limited. While this may simply reflect the fact that these proposals
did not meet the demands of the market place, our sense is that the difficulty
of co-ordinating decisions across institutions has also been a factor.

The key observation here is that co-ordination is sometimes required to make progress.
Payment systems are networks and for networks to work, institutions must sometimes
co-operate. Of course, institutions must also compete, and so the challenge
the industry faces is how to promote competition in the areas where it is required,
but at the same time promote co-ordination where it is required. This theme
is going to be taken up in more detail in a speech tomorrow by Governor Glenn
Stevens.

Looking forward, there is a strong case to re-examine the balance that has been struck
in the Australian payments system between competition and co-operation. Financial
institutions have been very good at competing on developing payment products
using the existing infrastructure, but they have not been so good at co-operating
to ensure that the infrastructure is improved over time. Ideally, we would
have world-class payment products, delivered on world-class infrastructure,
but unless the fundamental co-ordination problems in these networks can be
addressed there is a risk that this will not occur. These co-ordination issues
are best solved by industry, however, if this cannot be done, other options
will need to be looked at over the period ahead.